In 2004, Congress enacted
Sec. 7874 in response to a number of U.S. companies that
were reincorporating as foreign (i.e., non-U.S.)
corporations (primarily in tax-haven jurisdictions)
despite maintaining the majority of their headquarter
functions in the United States. In many cases, the U.S.
companies performing these “inversion transactions” had
few or no business operations in the foreign country of
reincorporation; the primary purpose of the transactions
was to reduce their overall U.S. federal tax liability by
shifting profits to low-tax foreign jurisdictions. U.S.
corporations and shareholders of such corporations face
potentially harsh tax consequences if they become subject
to Sec. 7874.

The financial turmoil of the past few
years has caused U.S. companies and foreign investors to
take another look at potential Sec. 7874 issues in certain
circumstances. The financial crisis has made it difficult
for U.S. companies to raise much-needed capital through
debt financing. Therefore, some U.S. companies are seeking
access to capital by going public on Asia Pacific
(ASIA-PAC) stock exchanges. There are many
reasons for this trend, but the most prevalent is that
countries in the ASIA-PAC region (e.g., China and Hong
Kong) have weathered the recession much better than other
countries. Due to these countries’ better current
financial condition, there may be more investors in
ASIA-PAC with capital to invest in initial public
offerings (IPOs) than in other markets. Another important
factor is that the ASIA-PAC exchanges often have
less-stringent reporting and filing requirements than more
traditional exchanges such as the New York Stock Exchange
or the London Stock Exchange.

U.S. companies going
public on an ASIA-PAC exchange may find it easier to do so
with a non-U.S. company such as a Hong Kong or a British
Virgin Islands–based company. This is achieved by taking a
foreign company public and at the same time causing the
foreign company to acquire the stock of the U.S. company.
The U.S. company’s shareholders receive publicly traded
stock in the newly created foreign company in exchange for
their stock in the U.S. company. Post-transaction, the
former investors in the U.S. company along with the new
investors who purchased the IPO shares collectively own
the foreign company, which in turn wholly owns the U.S.
subsidiary. In this foreign IPO context, Sec. 7874 may
create undesirable tax consequences for foreign investors
that invest in the new public foreign company.

Application of Sec. 7874 to Foreign IPOs

Sec. 7874 provides rules and thresholds that, if
surpassed, trigger harsh federal tax consequences for U.S.
companies attempting an inversion. A U.S. company is
generally subject to Sec. 7874 if:

Substantially all of the U.S. company’s property is
directly or indirectly acquired by a foreign company;
and

The former shareholders of the U.S.
company own at least 60% or 80% (with different tax
consequences for each).

Sec. 7874
provides special rules when calculating the 60%/80%
ownership thresholds if the inversion transaction involves
an IPO. Specifically, Sec. 7874(c)(2) provides that the
stock of a foreign corporation that is sold in a public
offering and is related to the acquisition of a U.S.
company (and indirectly substantially all of the U.S.
company’s property) is not included when determining the
60%/80% ownership thresholds. Even if new investors in the
IPO acquire a 41% interest in the new foreign company
(such that the former shareholders of the U.S. company
hold only 59% of the new foreign company), the former
shareholders are still deemed to hold 100% of the new
foreign company’s stock. Thus, in an IPO context, the
foreign company appears to fail the 60%/80% ownership
requirement regardless of how much stock is sold to new
investors.

If the new foreign company is subject to
Sec. 7874 in this case (i.e., more than 80% of the
former owners are owners of the new foreign company), the
new foreign company is treated as a U.S. company for all
federal tax purposes. This provision can have devastating
consequences for the new foreign company because it is
subject to U.S. federal corporate tax, withholding taxes,
and filing and reporting requirements.

Sec. 7874 and U.S. Withholding Taxes

If Sec. 7874 applies to the foreign IPO, as discussed
above, interesting issues arise for foreign (i.e.,
non-U.S.) investors with respect to withholding taxes on
dividends they may receive from the newly formed foreign
corporation. Under Sec. 881, the United States generally
imposes a 30% withholding tax (unless reduced by a U.S.
treaty) on dividends paid to foreign investors if the
income is from U.S. sources and is not effectively
connected with the conduct of a U.S. trade or business.
Under Sec. 861, dividends generally are considered to be
U.S.-source income if paid from the United States by a
U.S. company. Conversely, when a foreign company pays a
dividend to a foreign investor, that dividend is not
subject to U.S. withholding tax because it is considered
to be foreign-source income. However, if the new foreign
company is treated as a U.S. company under Sec. 7874, it
appears that the United States may recharacterize the
dividend paid by the foreign company to the foreign
investor as U.S.-source income. As such, the IRS may
impose a withholding tax on the dividends under Sec.
881.

In general, the 30% withholding tax imposed by
Sec. 881 may be reduced by an applicable U.S. treaty. At
first glance, if Sec. 7874 has caused the new foreign
company to be a U.S. company for all U.S. federal tax
purposes, it follows that the foreign company should be
eligible for reduced dividend withholding rates based on
the applicable U.S. treaty. Unfortunately, a further
analysis of the U.S. treaties leads to a different
conclusion.

Looking at the 2006 U.S. Model Income Tax
Convention (most U.S. treaties have similar language to
the Model Treaty), Article 1(1) states that the treaty’s
benefits “shall apply only to persons who are residents of
one or both of the Contracting States” (generally the
United States and the other treaty participant). Article
4(1) defines a “resident of a Contracting State” as “any
person who, under the laws of that State, is liable to tax
therein by reason of his domicile, residence, citizenship,
place of management, place of incorporation, or any other
criterion of a similar nature.” However, the new foreign
company is subject to tax in the United States based on an
inversion transaction and Sec. 7874 rather than any of the
listed criteria in Article 4(1). Thus, it appears that the
new foreign corporation is not a “resident” of the United
States and is not eligible for treaty benefits. If the
reduced dividend withholding rate under the applicable
treaty does not apply, the default 30% U.S. withholding
tax applies to all dividends paid by the new foreign
company to its new foreign investors.

Sec. 7874 and Double Taxation

Foreign
investors may also be subject to double taxation on the
dividends they receive from foreign companies that are
treated as U.S. companies under Sec. 7874. This situation
may arise if the foreign country imposes a withholding tax
on the dividends paid to the foreign investors. This
foreign withholding tax would be in addition to any U.S.
withholding tax imposed on dividends.

The ability
of the foreign investor to take a foreign tax credit for
any U.S. withholding depends on the law of the country in
which the foreign investor is a resident. If there is no
permissible foreign tax credit, the foreign investor faces
the following taxes:

Personal or
corporate income tax on the dividends (assuming the
foreign country taxes dividends as income);

Foreign withholding taxes; and

U.S.
withholding taxes.

This potential for
double or multiple taxation may lead to a significant
reduction in the after-tax amount that the foreign
investor may retain if paid a dividend from such a foreign
company.

Conclusion

Based on
the foregoing, it can be seen that there are significant
potential tax issues for foreign investors that invest in
a foreign IPO that is related to the inversion of a U.S.
company. It is strongly recommended that foreign investors
consult with their tax advisers to consider these issues
before making such investments.

EditorNotes

Kevin Anderson is a partner, National Tax Services,
with BDO USA, LLP, in Bethesda, MD.

For additional
information about these items, contact Mr. Anderson at
(301) 634-0222 or kdanderson@bdo.com.

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